Saturday, August 7, 2010

Reminiscences of a Stock Operator: Chapters 7 & 8

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore now shares some of his speculating techniques, many of which he has learned from other speculators. Livermore clearly believes speculation to not be the same as gambling. He believes his method of trading contains little to no elements of gambling, and therefore is safe. One of his abilities relative to other traders is that he is able to separate his opinions from his portfolio. Livermore claims a great many investors are simply bulls because they own stocks, but what they own should not affect their outlook.

Livermore buys when the market (or a security) is going up, and sells short when the market (or a security) is going down. If he believes a stock is going up, he will buy it, but not all at once. He first tests the water by placing an initial order. If the order is easily absorbed by the market or the price falls (or rises if he is short) despite the order, he will consider himself wrong for now and will get out. If the price rises on his buy, however, he believes there are more buyers than sellers out there and he will re-enter the market with a subsequent order. When one is unsure about the market's (or a security's) direction, Livermore advises placing test orders to determine how well the market absorbs an order. If the market is not absorbing well, there could be a big move and Livermore would enter with larger orders.

Before Livermore learned to employ the above technique, however, he was wiped out once more. In 1907 he saw a bear market coming, but was too early in selling short three straight times. A bull market was on, and when it looked like it was ready to fizzle out, Livermore jumped in with large sell orders that he eventually had to buy back at higher prices. The last of these cleaned him out completely. Because he generated lots of commissions for his broker, they fronted him some more money, and Livermore was finally correct about his predicted bear market. He made back a ton of money in a huge market sell-off.

If he buys or sells and the price of the security doesn't move, it means he was able to find a counter-party easily at this price, and that's what he means when he says the market absorbed his trade. If the price moves in response to his trade, it was not able to absorb it, and this is where he gets interested.